Bank of Japan goes with the flow
Faced with inflation rising in the first half of 2022 to levels not seen since the early 1980s, the Bank of Japan was forced to take action. With its Yield Curve Control (YCC) policy, the central bank implicitly told the market that the times of ultra-low borrowing costs have come to an end. The BoJ will seek to ensure a smooth transition towards a new rate regime, avoiding a massive and rapid tightening in financial conditions. It will therefore likely continue with very incremental increases in the YCC target band over the coming months, taking its cues from the Fed.
Markets will begin to price in a further shift in the YCC policy, but this will probably result in the appreciation of the yen in the short term, rather than any kind of steepening move on the government bond yield curve.
Small caps volatile but resilient
As inflation rises and interest rates are about to be hiked, higher interest and refinancing costs on loans are also weighing on companies’ cost of capital in Japan.
While inflation affects revenues as well as costs, there is often a mismatch between the pace and magnitude of cost increases and the pricing efforts to compensate for them. Operating and financing costs usually rise faster than they can be passed on to customers, and not all companies are equal in this regard. Firms with products or services for which demand is inelastic have more pricing power, as do those that can create a perceived value rather than depending on commodity prices.
Smaller Japanese companies are often the most vulnerable to volatility but also faster to recover than larger ones. This is why the 2022 turbulence has not changed our medium-term forecast significantly. We believe even the companies affected in the short term can catch up by the next fiscal year, but the market has not priced this in. We anticipate the current undervaluation will lead to a significant price recovery in the next 12–18 months. For reference, the current average EPS growth is still 35% for this year and is expected to be 27% for next year. Also, companies whose business is domestic should benefit from the strength of the yen.
These Japanese small caps continue to represent a large pool of firms from which active managers can pick out the highest-quality and most future-proof ones – those that combine fair valuations with high-quality features, such as strong management teams, good business models, solid balance sheets and leading positions.
The often-limited coverage from the sell side offers countless inefficiencies for seasoned bottom-up stock pickers. In addition, this segment provides investors with more domestic exposure to Japanese growth and, more importantly, to innovation.
A compelling investment case
In 2022, markets reacted to the combination of higher inflation and higher interest rates with disproportionately falling valuations in the more expensive parts of the market. In their haste to price in many potential hazards, market participants have failed to recognise the premium that should reward innovative activities.
Yet this has not to date been accompanied by lower earnings growth expectations despite the looming economic slowdown, and with Japanese multiples now below the historic average, we see less risk of a further derating.
Value-creating companies are fundamentally better equipped to be more insulated from a sharp economic slowdown and are far more agile in dealing with inflation; they should therefore be more valuable to investors.
Cédric Le Berre